The bull case for UK Real Estate Investment (REITs) far outweighs the bear case especially for the specialist REITS.
Experts in the REIT market believe that the wide discount that REITs currently trade at is potentially attractive, especially for businesses linked to the favourable mega trends of an ageing population, digitalisation, generation rent and urbanisation. Investors already in these sectors now will benefit from any positive change to current bearish sentiment.
For real estate stocks to fall further in price one would have to anticipate REITs being hit by even higher inflation and high base rates leading to increasing funding costs; or a sustained period of stagflation, with associated high bond yields pushing property valuation yields higher (lower property values); or a full brown recession with mass unemployment leading to lower rental income.
Matthew Norris, an investment adviser at Gravis, adviser to the VT Gravis UK Listed Property (PAIF) fund, said for investors to be bearish right now they have to believe that short rates go higher and stay higher.
“The Bank of England is expecting inflation to remain above 10% in Q4 2022 and Q1 2023, investment bank economists are forecasting the Bank of England base rate peaks at 4.25% in Q2, 2023 with an upper forecast of 5%; one month Sterling Overnight Index Average (SONIA) indicates interest rates to be 4.5% in Q2, 2023, remaining above 4.5% HS 2023,” said Norris. “So, to be bearish you have to believe that rates will go higher than that or else you are just in line with market expectations. Alternatively, you have to believe in a sustained period of stagflation, ie high inflation, no economic growth and that yields on five-year gilts go back above 4%.”
Norris thinks that while there are cautionary warnings of a recession it seems that this recession is a technical recession with full employment but periods of small contraction in the economy. The number of vacancies out there exceeds the number of people searching for work.
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Why stay bullish on REITs
A technical recession there shouldn’t be too bad news for real estate investors positioned in the growth mega trends. But to be bearish today you really have to believe in a classical recession, a mass unemployment recession where people lose their jobs, employers don’t rent office space, retailers close shops and people lose their homes. All of which leads to the case for being bullish and a re-rating of REITs due to attractive valuation levels, peaking inflation, strong balance sheets and rent growth.
“If you look at the UK REITs market as a whole, REITs are trading at a wide discount compared to historical averages,” Norris adds. “Historically UK REITs traded at about 12% discount to net asset value, today they are trading at 32% discount to NAV. While overall valuations look attractive stock picking remains key.”
Drilling down from the market to the mega trends, even high-quality real estate is trading at a discount, judging by Norris’ REIT holdings: “Ageing population REITs are trading at an 11% discount, generation rent REITs at 13% discount, digitalisation ones at 19% and urbanisation REITs at 39%,” he explains.
Market is pricing in outward shift in yields
Drilling down further to the actual stocks the equity market is already pricing in a significant outward shift in property yields: Warehouse REIT, for example, recently reported a 0.41%1 change in valuers yield from peak value, versus the market implying a likely change in valuers yield of c.1.06%2.
Further to the bullish cause is Bank of England forecasting 2.2% inflation in two years and the inflation rates implied by financial futures declining over time.
Low leverage and well laddered maturities protect REITs from near-term movements in interest rates and continued rental growth partially offsets higher funding costs. Additionally, there are two sources of rental growth, first contractual leases which benefit from indexation or fixed uplifts and rent reversions.
REITs such as Impact Healthcare benefit from contractual rental escalators so we should witness growing income from these through time and that growth and income should lead to a growth in dividends.
Rent reversion, which can be viewed as embedded growth helps to offset any outwards shift in valuation yields and rising financing costs and can be seen with the ‘digitalisation’ and ‘generation rent’ sectors. In these areas, market rents are higher than current in place rents and in time as those leases expire, they roll to higher market rents.
For example, SEGRO REITs’ rents could be 20% higher; Tritax Big Box 15% higher and within generation rent PRS rents could be 10% higher, Norris predicts.
Notwithstanding the positives however, stock selection Norris adds, is key.
